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National Institute of Economic and Social Research

Wednesday, 16 May 2012

Gilt yields and confidence (again): the Prime Minister vs. the Bank of England

I've written on this before in depth, most recently here, but I thought the juxtaposition of what the Prime Minister said today, and the Bank of England's analysis in its Quarterly Inflation Report, also today, was worth noting.The Prime Minister argued:

The fact is that today British interest rates are below 2% because the world has confidence that in spite of our economic difficulties we have a plan to deal with our debt and our deficit

The Bank has a rather different perspective (page 12):

Gilt yields remain close to historically low levels. Domestic and international factors are both likely to have depressed yields. Domestically, the MPC’s asset purchase programme and expectations that official interest rates will remain low have reduced gilt yields. The current level of yields could also reflect expectations of weak output growth in the longer term: the implied cost of government borrowing for five years in five years’ time is also close to historically low levels, largely reflecting low real rates. Internationally, persistent concerns about euro-area periphery countries have contributed to strong demand for sovereign bonds — including those of the United Kingdom — that are perceived as more liquid or carrying little credit risk. That is also likely to have contributed to the current depressed level of gilt yields."

Obviously, all the domestic factors identified by the Bank - the asset purchase programme (quantitative easing), expectations of low official interest rates, and expectations of weak output growth - reflect economic weakness, not confidence. If the economy was doing fine, we'd have significantly higher short rates, the Bank would be reversing QE, and expectations for the future would be for strong growth. Gilt yields would be higher, and this would be good news.

Internationally, the lack of credit risk on gilts definitely does help, as the Bank says, but of course we never lost it; what is going on is that credit risk is increasing for some eurozone countries. The difference is of course that we have our own currency, central bank and a floating exchange rate, as I explain here.

Reversing the QE program in the next 7 years will be impossible whilst the UK is still having to issue new debt to cover deficit spending. Reversing after 7 years will make no economic sense at all.

The first part of QE is where the Bank of England uses its privileges as a Central Bank to magic some money from thin air, buy outstanding Government debt from the banks and credit the reserves of private banks with the money it has created. This is the part that should be and is designed to be inflationary. Money is created and the banks should in theory be able to leverage the reserve crediting up and stimulate demand in the wider economy with it.

In the last couple of years the Bank of England has created £325 billion this way. So what has been the effect on the money supply?

"Figures released by the Bank of England on Wednesday showed that the UK's broad money supply, M4, shrank by 5pc in the past year to a new record low."

http://av.r.ftdata.co.uk/files/2011/11/200bn-QE.jpg

Without the £325 billion of QE and the UK government undertaking deficit spending the UK money supply would be contracting even faster than it is at the moment. Banks, households and the private sector have all been deleveraging since 2008. There just simply isn't enough money being created to sustain slow economic contraction let alone growth. QE obviously isn't working in the way it is intended. The credits given to banks are not finding their way into the real economy. QE is simply not stimulating growth in the money supply in the way it is intended to.

So what has gone wrong? In short - bankers greed. Banks demand a 15% return on equity to enable them to support their "business model". This level of return is so high and greedy that banks have no interest at all in lending for mortgages or to small businesses - the returns are too small.

As credit creation in banks is the only way the UK economy can widen its money supply and credit creation in banks is responsible for 97% of the money supply growth if banks won't lend then the money supply doesn't grow and our economy shrinks.

The other possible source of monetary growth other than QE or credit creation by banks is Government spending but since Osborne is taking many multiples of £150 billion out from public sector spending this virtually guarantees we enter a depression.

Is there a silver lining though? Yes - the Bank of England has successfully bought up a third of the government debt that Cameron and Osborne are blathering on about without sparking an inflationary spike in the money supply.

Given that everybody was expecting QE to feed through into growth in the UK money supply there was always planned to be a second part to QE.

The second part of QE is the insane bit. Sitting in the wholly publicly owned Asset Purchase Facility is £325 billion of outstanding government debt. The same debt Cameron says it is critical we eradicate. His plan for it is that in a few years time, the Asset Purchase Facility should sell this government debt back out to the banks we bought it off and then rip up the money the banks give us for it. Given the original reserve crediting didn't cause the money supply to widen this is just treasonous and insane.

The resale part of the QE operation obviously can't be inflationary - the money creation bit from part one happens over 5 years before the reissue of gilts. I can see how the re-issue could be deflationary as banks will allocate liquidity to buy the gilts instead of using the money for something else. But it just cannot be inflationary as there is no money creation at that point.

Given the way the UK money supply is operating despite QE, the second part of QE should be abandoned. A sensible government would announce that the money supply is shrinking, that the £325 billion in the Asset Purchase Facility can be safely monetized and that public sector cuts can be cancelled and a £175 billion stimulus package can safely be afforded.